Introduction
Economists put a large emphasis on personal consumption and how people consume because consumption accounts for roughtly 2/3 of the gross domestic product (GDP). Why is consumption theory important to you? It is threefold: everything about consumption: groceries, cars, houses, schools, etc,; everything about labor income, specially due to trade imbalance; and everything about consumption and income will affect your personal saving!
What we will see here is that consumption theory deals with three variables: income, consumption and savings.
By definition, savings = income - consumption
In Keynes, the relationship between income and consumption or the consumption function is given by
consumption = a + b x Income
Basically, it assumes more income more consumption and vice versa due to a propensity to consume or propensity to save.
In modern micro economics approach, consumer maximizes their utility under a budget constraint. This approach optimizes consumpton by employing Euler equation approach.
In spite of using the wrong optimization technique, we will see that Keynes assumed a "simple principle" that is actually the right conclusion on change in savings. To prove Keynes' insight, we must apply Clower's Dual-Decision Hypothesis. Wu's proof is that change in saving is a function of change of income or income growth. This result also puts to rest Modigliani's Life-Cycle Hypothesis and Friedman's Permanent Income Hypothesis. It shows that Keynes' principle and Lucas' Critique on consumption reached the same conclusion, 40 years apart. Because of an implausible assumption, it further shows why Hall's consumption result couldn't hold in data.
We will see that consumption theory has at least two important applications: 1. While the Trump administration I and II trade policy narrowly emphasizes the effect of trade deficit on manufacturing, the consequence of a more balanced trade should result in an increase in income and saving, which is predicted by Keynes-Clower-Wu consumption theory. 2. Due to a skewed electoral college system in the U.S. favoring farm states, farmers optimize their choice of president by selecting whoever is more likely to increase their future income, i.e., making the selection a president no more different than the "consumption" of any other service.